The Bad News Is, ‘The Next Recession Could See The Third-Worst Spread Peak In History’

Reams have been written – or, in a digital world, we can say “gallons of digital ink has been spilled” – documenting the explosion of debt and the steady rise in a variety of ostensibly key leverage metrics in a world of artificially suppressed borrowing costs and, as it relates to corporate borrowers, perverse management incentives that encourage financial engineering.

The problem with most of this analysis – and I’m speaking in generalities here, so cut me some slack – resides in trying to figure out the best way to measure “risk” in an environment where central banks are acutely aware of the extent to which a world awash in debt simply cannot handle higher rates, especially in the absence of inflation.

“Given the excessive debt burden the world has (mostly outside of the corporate sector), it seems likely the authorities will try to ensure real yields stay historically low in the years ahead, regardless of what happens to nominal yields”, Deutsche Bank’s Jim Reid writes, in the 21st (!) edition of the bank’s annual default study. “Thus, defaults could continue to stay structurally low in the years ahead, notwithstanding the obvious spike when the next recession hits”, he adds.

 (Deutsche Bank)

The full study is 50 pages long and thereby isn’t amenable to any kind of “summary” treatment, but one of the key points is that, as Reid writes, “notwithstanding the higher defaults associated with the next recession, we think we’re more likely to continue in a structurally low default world as far as the eye can see.”

Expounding on that, he also notes that when it comes to levering up this cycle, investment grade corporates are the culprits, aside from an obvious spike in high yield leverage around the oil collapse.

(Deutsche Bank)

“[Because] defaults generally come from HY companies, the risks here might be future IG fundamentals deteriorating and market technicals being challenged (e.g., IG to HY downgrades”, Reid continues.

As a quick aside, it’s also important to note that when you look at, for instance, net debt to profits, the “problem” doesn’t look so problematic, if you will. To wit:

Because corporate profits are such a high share of GDP at the moment – and have been for the last few cycles – debt levels look relatively mild on this measure, and the increase in this cycle also looks fairly tame. In terms of net debt, the picture looks even more sanguine with leverage on this measure running at the lower end of its 70-year range.

Obviously, there is all manner of additional nuance to this discussion and you’ll just have to trust me when I tell you that over the course of four-dozen pages, Deutsche does not skimp on that nuance.

But what we wanted to highlight here is the discussion of liquidity, because if you’ve been paying attention over the past several years, you know that liquidity concerns are paramount in the corporate debt market in light of a post-crisis regulatory regime that leaves the street hamstrung in its ability/willingness to lend its balance sheet in a pinch and, crucially, the rampant proliferation of retail vehicles (e.g., HY and EM debt ETFs) which feature a structural flaw (i.e., they promise intraday liquidity against an underlying basket of illiquid bonds, which is a philosophical impossibility no matter what anybody tells you).

For the above-mentioned Reid, the problem during the next downturn will not be defaults (or at least not outside of what you would normally expect during a recession), but rather liquidity.

“It feels unlikely that in the next downturn defaults will rival those seen in recessions in the pre-2004 period where real yields were higher”, he says, before warning that “what is highly likely, though, is that there will be some huge technical problems for the market to deal with in the next recession.”

One of those problems revolves around the much ballyhooed “BBB apocalypse” which we’ve spent hours (and hours and hours) documenting in these pages. Fallen angel risk is clearly a concern given the size of the BBB market and the potential for mass downgrades when the cycle turns. “This will likely lead to big spread dislocations as the HY market struggles to deal with the size of some of these ‘super’ BBB issuers”, Deutsche writes.

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But that may not be the biggest worry. Rather, Reid suggests that the real risk may come from a lack of liquidity in a falling market given the post-crisis landscape. To wit, from the note:

More importantly, the overall market dynamics have shifted aggressively since the GFC. Figure 41 republishes a chart we have shown on numerous occasions over the last several years detailing that the US corporate bond market has near tripled in size since the GFC due to QE, lower yields encouraging companies to issue and high demand for fixed income and spread product, thus providing a captive pool of capital. Meanwhile, regulation has ensured dealers/market-makers have less and less ability to warehouse risk. Figure 42 then looks at US IG, HY and Treasury daily trading levels relative to the size of the market.

This is an issue folks have been warning about for years and, generally speaking, a lot of those folks have been maligned as Chicken Littles.

As we’ve been at pains to point out – and eventually, we just stopped beating the dead horse, because at this juncture, it’s clear that anyone who doesn’t understand this is either being deliberately obtuse or else is just a silly person, incapable of grasping an inherently simple concept – this isn’t a debatable point. This is a problem and one day, it will manifest itself in a firesale. That’s not to say the firesale has to be the end of the world, or that it will trigger a collapse which in turn presages the apocalypse. It’s just to say that this particular “criticism” is less “critique” and more “statement of fact.” Here’s how Reid puts it:

This size-versus-liquidity dynamic doesn’t matter when the economy is growing, fundamentals are stable, and we see consistent inflows. This has been the general situation over the post GFC period bar a few mini wobbles (e.g., October-December 2018) where we have seen sharp spread reversals. These wobbles, though, have rarely been caused by concerns of an imminent recession. When the next recession does hit, we will likely see huge outflows and investors scrambling to sell to fund these outflows and also to try to protect performance. This will likely mean severe credit spread widening and a major decoupling from default risk.

That passage is headline-worthy enough on its own, but the real kicker from Reid comes in next paragraph when he explains how this will ultimately be “resolved”:

So, it’s quite possible the next recession will see the third-worst spread peak in history (behind only the Depression and the GFC) due to these market dynamics. However, these peaks may not last long as central banks will probably be forced to buy to ease pressure on the market. In fact, this is probably a more traditional function of central banks: to lend money to solvent entities when there is a liquidity problem. Companies are unlikely to have liquidity problems, but those holding the bond might well do.

Any questions?